Feb 282011

Figuring out how to divvy up a new company’s stock among its founders is often the first thing those founders have to work through.  Part of the discussion is always some variant of “what happens if we go two months down the road and one of us pulls out”?  And, the answer to that is always vesting — the founder gets the stock now, but the company can buy all, or part, of it back if the founder leaves too soon.   But, both the company and founder need to watch out, because that “restricted stock” can get them into trouble.

The trouble comes from a provision in the tax code  that, basically, says “If you receive stock subject to vesting, then you have to pay tax on the difference between what you paid for the stock, and its fair market value at the time it vests.”

Think about what happens with stock subject to monthly vesting: every month, the taxpayer needs to figure out what the value of the stock is on the day it vests, subtract from that whatever he paid to acquire it, and pay taxes on the difference.  Even worse, just figuring out the value of shares of a privately-held company can be time-consuming and expensive.  And, to top it off, your employer has to calculate and withhold this amount from your pay!   What a mess!

Luckily, there’s an easy way out of this if you act fast: the IRS lets you treat the stock as if it vested all up-front, by filing what’s called an ’83(b) election’ with the IRS within 30 days of the stock award.   If you do that, then the only thing you pay tax on is the difference between what you paid for the stock, and what it was worth on the day you bought it.  With a start-up company, that amount is usually $0.

Uncharacteristically, the IRS does not have its own form for making the 83(b) election.  So, I’ve posted a 83(b) election form that does it on the Resources page.  As always, you should consult your own attorney and/or tax advisor to make sure that it’s appropriate for you.